The main benefit of asset segmentation is to focus the allocation decision process on the key drivers of asset returns. Therefore, investors should spend time on articulating their beliefs about what they consider such drivers to be: broad asset classes, factors, geographies, investment styles or investment purpose (e.g., return, income, hedging).
The traditional segmentation is by asset class, based on the well-established diversification between equities and bonds, with geography often considered as a secondary source of diversification within each major asset class. Some investors also define an ‘alternative assets’ bucket, including private equity, private debt, real estate and infrastructure, even though this means grouping highly diverse types of assets around a common factor: their reduced liquidity compared with traditional assets. This approach to segmentation was challenged during the 2008 crisis, when the expected diversification provided by certain so-called asset classes (hedge funds in particular) proved to be illusory in the context of falling markets.
The following years saw the emergence of factor diversification, which eventually disappointed many investors, not so much due to the failure of this concept, but rather to the dominance of growth strategies that prevailed in a context of easy monetary policy and record-low interest rates, limiting the benefits of this source of diversification.
How do institutions approach the issue? Based on our analysis of the public information provided by large institutional investors and our discussions with a selection of these, we observe that most investors implement some form of asset allocation segmentation. The most common practice seems to be the traditional allocation across asset classes (with a segmentation between equity and fixed income) due to its practical advantages, but a number of institutions have segmented their allocation in terms of economic purpose or risk, encompassing a growth-hedging or a return-income generation segmentation. Pension funds, in particular, usually split their allocation between growth – largely composed of equity-related strategies – and hedging (or safe-haven) assets, composed of high-quality bonds. This approach has a significant overlap with the traditional equity-fixed income allocation split, but it has the advantage of providing investors with more flexibility to allocate to other types of assets that may have equity-like or bond-like features, including real estate or infrastructure for the latter. Some investors, including a major Australian pension fund, have also decided to allocate their portfolio in terms of risk premia which are identified by the potential reward they offer, such as illiquidity, credit and FX carry, rather than by asset class.
In figure 1 we present different examples of purpose-based asset segmentation. In the first one, a major Asian pension fund decided to split its allocation between return enhancement, capital preservation, inflation hedging and day-to-day operation portfolios. In the second one, a major European pension fund split its allocation between a growth and a hedging portfolio.
Some investors have adopted a mixed approach, combining the traditional allocation by asset class with additional categories such as ‘liquidity’, ‘overlay’ or ‘opportunities’. This mixed approach can also combine an allocation to traditional asset classes and its implementation by factors within these. For instance, a given allocation to equities can be implemented by investing in equity factor strategies which, in the case of high-dividend or low-volatility strategies, are designed to help mitigate portfolio volatility.
In addition, liquidity can be another segmentation axis. This implies splitting assets between those that are fully liquid – especially during crisis times; those that offer limited liquidity – as is the case of most private assets; and those in-between – such as high-yield debt – whose liquidity depends on market conditions and on the size of trades. Such liquidity segmentation helps ensure that the investor can meet liability requirements while benefiting from the illiquidity premium.